It is well known that banks play an important role in monitoring borrowing firms (e.g., Diamond, 1984). Yet, how banks choose among alternative mechanisms that reduce agency costs with borrowers is not completely understood. In our paper, “Bank Relations and Borrower Corporate Governance and Incentive Structures,” we document that, as banks and borrowers develop closer relationships, borrowing firms adopt corporate governance and incentive structures that help to reduce the banks’ risk of expropriation by the managers and shareholders.

While some bank monitoring can constrain managerial opportunism and thereby benefit debtholders and shareholders, banks also protect themselves against actions that benefit shareholders at the expense of debtholders. This expropriation risk stems from the differences in the payoff structures of debtholders and shareholders (e.g., Jensen and Meckling, 1976). Two common vehicles for such expropriation are asset substitution (i.e., borrowers use the funds to engage in high variance-high return investment projects, which benefit shareholders only, as debtholders always receive a capped return) and claim dilution (i.e., borrowers contract new debt with other debt providers with equal or higher priority). Banks, like other debtholders, are most sensitive to negative changes in firm value. As such, banks often include covenants in loan contracts to allow for renegotiation if borrower performance does not meet the lenders’ expectations.

However, given that the future cannot be predicted, covenants are unable to provide banks complete protection against all contingencies. Lenders can then also rely on other governance and incentive mechanisms to try to reduce the risk of expropriation. For instance, they may increase managers’ sensitivity to bad performance by entrenching them or providing them fewer risk-taking incentives (e.g., decrease the sensitivity of their stock option portfolio to stock volatility, or “vega”). Similarly, banks can have a bank representative sit on their borrowers’ boards of directors. As these incentives and governance mechanisms are not explicitly written into the debt contracts, we refer to them as non-contractual mechanisms.

By aligning shareholders’ and debtholders’ incentives, non-contractual mechanisms lower the expropriation risk faced by banks, allowing them to monitor their loans more effectively. On the other side of the transaction, borrowers enjoy greater flexibility afforded by the lack of contractual provisions, such as covenants or pledged collateral which can constrain their actions, and benefit from greater availability of future funding opportunities created by the closer relationships with their banks. Non-contractual mechanisms, though, are likely more expensive to initiate than the provisions usually found in debt contracts. For example, the process of a borrowing firm electing a bank-affiliated employee to its board of directors in order to increase managerial oversight is a much larger commitment than simply including debt covenants in loan contracts. The benefits of non-contractual mechanisms are that they potentially create repeat interactions between the contracting parties. In this way, non-contractual alignment mechanisms are similar to up-front investments that lower future incremental costs of transacting. Alternatively, when borrowers and lenders engage in arms-length transactions that are infrequently repeated, we expect contracting parties to rely more on the traditional, contractual mechanisms, such as accounting covenants.

Using a large panel of data, we examine whether and to what extent borrowers and lenders use non-contractual mechanisms as they enter into stronger relationships with their lenders. We find that as the borrower-lender relationship becomes stronger (e.g., when the number or amount of loans between a borrower and lender increases or when the lender becomes responsible for a larger share of a firm’s funds), borrowers are more likely to adopt corporate governance structures that reduce lenders’ expropriation risk and facilitate bank monitoring. These structures include having bank-related members on their board of directors (i.e., bank-firm interlocks), insulating managers from turnover (i.e., managerial entrenchment), decreasing managerial risk-taking incentives (i.e., decreasing vega), and increasing information asymmetry with other capital providers (i.e., higher bid-ask spread on the equity market).

Our results highlight a class of non-contractual, governance mechanisms that borrowers can use to reduce the agency cost of debt. Complementing the literature on debt covenants, where lenders obtain additional control rights ex post upon a violation of loan covenants, we examine mechanisms that operate ex ante. Additionally, our study offers further insight into the importance of context in determining the value of corporate governance structures. Studies have stressed how bank monitoring improves borrowing firms’ corporate governance, implicitly assuming that the incentives of shareholders and debtholders are aligned regarding corporate governance. We show that this may not be the case. As borrower-lender relations strengthen, borrowing firms are more likely to adopt corporate governance structures traditionally associated with lower shareholder value (i.e., CEO entrenchment, greater insider participation on boards, and less transparency in external reporting). While these governance structures might be detrimental to shareholders in other circumstances, our evidence suggests that firms find the net benefits to be positive in situations where there is sufficient scope for repeated interactions with lenders.

This post comes to us from Professor Carlo Maria Gallimberti at Boston College, Professor Richard A. Lambert at the University of Pennsylvania, and Jason J. Xiao at the University of Rochester. It is based on their recent article, “Bank Relations and Borrower Corporate Governance and Incentive Structures,” available here.